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Currency and the subterranean economy
Proposed redefinition of money stock
Banks and the securities markets:
the controversy
Holding company affiliation and scale
economies in banking

Currency and the
subterranean economy

There has been a large increase
in currency holdings, in part reflecting
illegal transactions.

Proposed redefinition of
money stock measures

March/April 1979, Volume III, Issue 2

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Due to recent regulatory changes
and financial innovations that have
rendered current measures less
meaningful, a redefinition o f the
monetary aggregates has been

Banks and the securities
markets: the controversy


Over the past decade, commercial
banks have caused controversy by trying
to expand their currently limited role
in the securities markets.

Holding company affiliation and
scale economies in banking
The effect of affiliation with a
holding company on the cost structure
of banks has been a controversial sub­
ject in banking for some time.


Currency and the
subterranean economy
Robert D. Laurent
C urrency holdings have always fasci­
nated the public. The fascination is only
heightened by the lack of hard data that con­
fines investigators to conjecture in explaining
currency holdings. Growth in the number of
checking accounts and the expanding use of
such currency-saving instruments as credit
cards have often led to predictions of a
“ cashless society." Yet along with the growth
in credit cards and checking accounts there
has come a large increase in currency
Currency in circulation has increased
nearly 13 times in the past 40 years, boosting
per capita holdings to $510. Even casual ob­
servation indicates that $2 ,0 0 0 in currency is
more than a family of four needs for ordinary
Aside from the increased use of checking
accounts and credit cards, there are other
reasons for expecting the use of currency to
decline. Holding wealth in the form of
currency is risky as it can be lost or stolen. On
the other hand, experience with widespread
deposit insurance shows that holding wealth
as deposits is relatively risk free. Also, curren­
cy holdings sacrifice interest returns, which,
with the rise in interest rates, have become
One possible explanation for the rapid
growth has long been recognized. That is
currency held for illegal purposes. Higher tax
rates would seem to increase the use of
currency to avoid taxes. There is also some
feeling that certain inherently illegal activities
have expanded greatly, particularly dealings
in illegal drugs. Transactions of this sort would
necessarily be made in currency.

Federal Reserve Bank of Chicago

Subterranean economy estimate

Reliable data on currency usage in illegal
activities are, of course, hard to obtain. This
explains the widespread attention given to a
recent estimate of currency usage in what is
called the “ subterranean economy." In this
underground economy, activities are either
inherently illegal or not reported to avoid tax­
es. In an article in the Financial Analysts Jour­
nal (November/December 1977), Peter M.
Gutmann used the ratio of currency to de­
mand deposits to estimate the amount of
economic activity in the subterranean
economy. He estimated that activity in the
subterranean economy amounted to at least
$176 billion in 1976. That was nearly a tenth of
the reported GNP.
Gutmann used the currency stock and
demand deposit holdings in a straightforward
way to estimate the magnitude of illegal ac­
tivity. Over the period 1937 to 1941, the ratio
of currency to demand deposits was 21.7 per­
cent. By 1976, the same ratio had risen to 34.4
Assuming (1) that a dollar of currency and
a dollar of demand deposits support the same
amount of economic activity (legal and il­
legal) at the same point in time, and (2 ) that
the ratio of currency to demand deposits
needed to support legal activities had not
changed, he figured that illegal activity had
increased substantially. Even if there was no
illegal activity in the earlier period, illegal
activity in 1976 would amountto$176 billion.
There are some important implications
involved in this estimate, however. One is the
implication that economic activity (legal and


illegal) associated with currency has grown
faster than activity associated with demand
deposits. Another is the implication that a
dollar in currency or demand deposits sup­
ports about twice as much GNP activity in 1976
as it did in the earlier period. This follows
because GNP averaged $98 billion in 1937-41
and currency plus demand deposits (M-1)
averaged $33.6 billion. Every dollar of M- 1 ,
therefore, supported $2.9 of GNP in 1937-41
and $5.6 in 1976. Most important, the estimate
depends critically on the use of demand
deposits as the "yardstick" magnitude com­
pared with currency. This choice determines
not just the estimate of growth in the sub­
terranean economy, but whether there was
any growth at all. For example,comparison of
the ratio of currency to total bank deposits
shows currency declined relative to total bank
deposits from 1939 through 1976. Indeed,
over the period 1959 through 1978, of the five
money measures (all including currency) that
the Federal Reserve reports, currency de­
clined as a proportion of all except M- 1 . This
comparision suggests that what was striking
about this period was the slowness of growth
in demand deposits. Currency did not in­
crease relative to other deposit measures.

before an exchange can be made for goods
and services. This implies that currency and
demand deposits should be more closely
related to GNP. They perform the transfers
associated with the production of goods and
The analysis that leads to a focus on the
behavior of currency relative to demand
deposits suggests that transfers of currency
and demand deposits would be more in­
dicative of economic activity than the stock of
currency and demand deposits. Activity
carried out in the visible economy requires
payments for labor and materials, probably by
check. Once an activity is carried out at least
partially in the subterranean economy, even
transactions that are in the visible economy,
such as purchases of materials, may be paid
for with currency.
It might seem that emphasizing currency
and demand deposit transfers instead of the
stock of currency and demand deposits gives
little new insight into illegal activity. Nothing
could be further from the truth. Figures are
available on the turnover of demand
deposits—the average number of times a
dollar of demand deposits transfers overtime.
The average from 1937 through 1941 was 21
times a year. In 1976, it
Some evidence from stocks . . .
was 117 times. De­
mand deposits outside
New York—a series
that re d u c e s the
Currency stock (billion dollars)
Demand deposit stock (billion dollars)
effects of purely fi­
Currency/dem and deposits
nancial transactions—
"Excess” currency/dem and deposits
turned over an aver­
Reported GNP (billion dollars)
age of 2 0 times a year
“ Excess” currency/((M -1) - "excess” currency)
from 1937 through
GNP output of subterranean econom y (billion dollars)
1941. In 1967, they
turned over 80 times.
Importance of transfers

There are compelling reasons for think­
ing M-1 is the best money magnitude to relate
to GNP. Currency and demand deposits are
the only components of any money measure
that can be immediately transferred for goods
and services. Other deposits must first be
transferred into currency or demand deposits


One of the main reasons for the faster de­
mand deposit turnover has been the effect of
increasing interest rates, which have en­
couraged better management of cash
balances. Banks are prohibited from paying
explicit interest on demand deposits and ris­
ing interest rates have increased the foregone
income represented by demand deposits.
This leads the demand deposit holder to
Economic Perspectives

economize and reduce idle balances, in­
creasing the turnover of demand deposits.
The increase observed in turnover further
reinforces the earlier observation that de­
mand deposits have behaved vastly different
among deposits in growing so slowly.
Impact of transfers

From 1937 through 1941, the average life
of a dollar of currency was 3.12 years. In 1976,
it averaged 5.31 years.1 With the assumption
that the number of transfers in the life of a
currency note did not change, the data in­
dicate that currency in 1976 transferred only
about 59 percent as fast as in the earlier
By use of the changes in transfer rates for
currency and demand deposits and with the
assumption that currency transfers accounted

The increase in demand deposit turnover
has important implications for estimates of
the subterranean economy. Debits to de­
mand deposits increased by more than 30
times over the period from
. . . and from transfers
1939 to 1976. By contrast,
the currency stock in­
creased only 1 2 times.
Unless the turnover rate
Currency stock (billion dollars)
Currency turnover (per year)
for currency has also
Currency transfers (billion dollars/year)
increased substantially,
Demand deposit stock (billion dollars)
g ro w th in c u rre n c y
Demand deposit turnover (per year)
transfers has actually
Demand deposit transfers (billion dollars/year)
lagged growth in demand
Currency stock/demand deposit stock
Currency transfers/demand deposit transfers
deposit transfers over this
period. Demand deposit
W here c represents currency transfers per year in the period 1937-41.
transfers put an entirely
different perspective on
the changes in currency
r e la t iv e to d em and deposits.
for the same proportion of transactions as in
Moreover, what scant evidence is
the earlier period, it is possible to compute
available suggests that currency turnover has
what the ratio of currency to demand deposits
actually slowed rather than increased over the
would have been in 1976. The result is that
past 40 years. Although there is no direct
currency in 1976 would have to be 1.45 times
the level of demand deposits. The combina­
evidence on currency transfers, a rough idea
of the velocity of currency transfers can be in­
tion of the speedup in demand deposit turn­
ferred from observing currency redeemed
over and the slowing in currency turnover
and destroyed. Currency is redeemed and
means that currency would have to be larger
destroyed when notes show signs of wear. If
than demand deposits in 1976 to perform the
currency becomes worn as a result of
same proportion of transfers that it did from
transfers, then the volume of currency
1937 through 1941. In fact, the ratio of curren­
redemptions and destructions can be used as
cy to demand deposits in 1976 was only 0.34.*
an indication of currency transfers.
This interpretation is supported by
evidence on destruction of different
’The increase in currency lifetime may be due, in
denominations. Smaller denomination notes
part, to a conscious decision by the Federal Reserve to
are more suitable for most transfers. Larger
iengthen the life of a note through changes in its curren­
denomination notes are more suitable for
cy redemption policy in the mid-1970s. However, ex­
amining data from the early 1970s indicates there was a
storing wealth. It has long been observed that
substantial increase in currency lifetime aside from the
denomination and currency lifetime decline
effects of any changes in Federal Reserve redemption
together, presumably as transfer velocity

Federal Reserve Bank of Chicago


Two trends

Adjustment for turnover changes the in­
terpretation of the currency stock numbers
completely. Instead of a currency stock that
seems too large, the stock now appears far too
small to perform even the same proportion of
transfers as in 1937-41. Yet the currency stock
and the per capita holdings have risen sharp­
ly. The explanation appears to lie in two dis­
tinct trends. One trend does, indeed, seem to
be a move toward a cashless society, with
currency performing a smaller and smaller
proportion of transfers in the economy. Ap­
parently, the growth in the use of checking
accounts and credit cards is substituting for
currency transfers.
A second trend has been a growing use of
currency as a store of value, with much lower
turnover rates. The rapid increase in $100
notes, until there is now more money out­
standing in this denomination than any other,
could reflect the increased use of currency as
a store of value. Even larger denominations
might be used if they were still issued. This
trend in large denomination notes could easi­
ly be connected with illegal activity, but these
notes do not have the same relationship to
economic activity as in the visible economy.
Why illegal activity might increase the
stock of currency while reducing the turnover
rate can be seen in a comparison of the
problem facing a small tax evader with the
problem facing a large tax evader. The small
tax evader evades the tax on a relatively small
part of his income. As his biggest risk is that
the unreported income will be detected, the
small evader uses a currency transaction to
receive the income in a way that cannot be
detected. Having received the currency, the
small evader has no problem disposing of it,
since it is a small amount relative to his in­
come. The small evader is affected by the
same factors that lead the holder of legally ob­
tained currency to economize on his curren­
cy holdings—the interest return that must be
foregone to hold currency and the de­
preciating value of the dollar.
The large tax evader may be required to


hold much larger amounts of currency that
transfer much slower. Notice that with a
currency per capita figure of $510, casual
observation suggests that currency holdings
are sharply skewed with some holders having
very large amounts. Large tax evaders have
the reverse problem of small evaders. Since a
great part or all of their income is hidden from
the tax collector, it is likely that the payments
are already arranged in currency. However,
there is a danger in transferring it into visible
assets. Visible assets substantially greater than
previously reported income could arouse
suspicion. If the income came from an activity
that was itself illegal, the currency holder
might even purchase a legitimate business
and “ launder” the illegal income by pumping
it through the business and paying taxes on it.
This might explain the reputed attraction for
large scale organized crime of such currency
intensive businesses as legalized gambling,
where large amounts of currency could be
One piece of supporting evidence for the
difficulty of eliminating currency hoards
comes from the period just after the Second
World War. Currency increased rapidly dur­
ing the war. This presumably reflected an in­
crease in illegal activities, hoarding as a store
of value, and increased foreign holdings.
Currency declined after the war. The decline
was slow and protracted, however, as though
currency hoards could not be disgorged
quickly. Per capita currency holdings actually
declined for 15 years—from 1946 to 1961.
The evidence presented here does not
deny the possibility that illegal activities have
been growing. Indeed, increasing tax rates
would seem to increase the incentive for such
activities. Nor does the evidence deny that a
great part of the increase in currency may be
due to illegal activities. The analysis of de­
mand deposit and currency transfers does
suggest, however, that the proportion of total
economic activity associated with currency
has declined substantially over the past 40
years. Thus, it seems unlikely that the
subterranean economy could presently
account for a tenth of reported GNP.

Economic Perspectives

Proposed redefinition of
money stock measures
Anne Marie Laporte
This article summarizes proposals by the staff
of the Board of Governors for redefining the
monetary aggregates that were presented in
the January 1979 Federal Reserve Bulletin. The
proposals raise important issues regarding the
payments system, the evolving role of
depositary institutions, and the basis on which
the public chooses to hold various financial
assets. To aid in further consideration of these
proposals, comments are invited from the
public. Please address comments to Office of
the Staff Director for Monetary and Financial
Policy, Board of Governors of the Federal
Reserve System, Washington, D.C. 20551.
"M oney" is generally defined in terms of the
functions it serves—medium of exchange,
standard of value, and store of purchasing
power. And because the Federal Reserve has
primary responsibility for regulating the
volume of money available to meet demands
of the public, it devotes significant resources
to measuring "m oney." Recognizing that
different financial assets serve different
money functions and that no one measure of
money is adequate for all purposes, the
Federal Reserve currently publishes six
measures of the money stock.
The current measures, however, have
become less meaningful as a result of recent
regulatory changes and financial innovations
that have changed the character of the
public's monetary assets. And as a result, the
staff of the Board of Governors has proposed
a redefinition of the monetary aggregates to
replace those currently published .1 The
proposed redefinitions take into account the

changing character of the public’s financial
assets, as well as some of the recommen­
dations of the Advisory Committee on
Monetary Statistics (the Bach Committee ).2
This article summarizes the staff's proposal.
Evolution of the current
monetary aggregates

While many financial assets serve the
standard of value and store of purchasing
power functions of money, only a few are
accepted as a means of payment—that is, for
making transactions. When introduced in
I960,3 the measure of money based on daily
average data published now as M-1
represented financial assets that could be
used directly in transactions. Although
refinements and revisions to the data have
been made since, current M-1 is still defined
in basically the same way, as the public's
holdings of currency, coin, and demand
deposits at commercial banks. The "public"
means exclusive of holdings by commercial
banks and the U.S. government.
It has long been recognized that various
savings instruments provide potential
purchasing power. They were not originally
included in the measured concept of money,
however, because they usually had to be con­
verted first into cash or demand deposits
before the funds could be used for transac­
tions. Nevertheless, related data on all com­
mercial bank time deposits, also measured on
a daily average basis, were published
2lmprovingthe Monetary Aggregates: Report of the
Advisory Committee on Monetary Statistics, (Board of
Governors of the Federal Reserve System, June 1976).

’ “ A Proposal for Redefining the Monetary
Aggregates,” Federal Reserve Bulletin, January 1979, pp.

Fe d e ra l R e se rv e Ba n k o f Chicago

3“ A New M easure of the M oney Supply,” Federal
Reserve Bulletin, O ctob er 1960, pp. 1102-21. Monetary
data published prior to late 1960 was as of a single day.


separately beginning in 1962.
It was often argued that a broader
measure of money was sometimes more ap­
propriate. And while broader measures could
be constructed from data published by the
Federal Reserve, not until 1971 was more than
one money supply measure, labeled as such,
published. That was when M-2 and M-3 were
Then, as now, M-2 was defined as M-1
plus commercial bank time and savings
deposits other than large negotiable CDs
issued by large banks. As first introduced, M-3
included M-2 plus mutual savings bank
deposits and savings and loan shares. In 1975,
when the number of published monetary
aggregate measures was increased to five,
M-3 was redefined to also include credit
union shares.
The two additional money stock
measures introduced in 1975 were M-4 and
M-5, defined by adding large negotiable CDs
to M-2 and M-3, respectively. Thus, current
M-4 represents public holdings of currency,
coin, and all deposits at commercial banks,
while current M-5 represents public holdings
of currency, coin, and all deposits at banks
and thrift institutions.
Because of the uncertainties associated
with the introduction of prearranged
automatic transfers from savings to checking
accounts (ATS), a sixth monetary aggregate
measure, M-1+, was introduced in late 1978.
Current M-1+ includes M-1 plus savings
deposits at commercial banks and transac­
tions accounts at thrift institutions. Although
M-1 is affected by deposit shifts between de­
mand and savings accounts subject to ATS,
such shifts do not change M-1+. The introduc­
tion of ATS and the development and growth
of transactions accounts outside the commer­
cial banking system are two factors leading to
the proposed redefinition of the monetary
Changing character of the public’s
monetary assets

As a result of regulatory changes and
financial innovations, the character of the

public's monetary assets has undergone basic
alteration in the 1970s. In some cases, certain
types of deposits have become more alike.
Others have become more dissimilar. In addi­
tion, distinctions between deposits at
different depositary institutions have become
Some developments have increased the
number of financial instruments that can be
used for making transactions. These include
the authorization of negotiable orders of
withdrawal accounts (NOWs) in some states,
credit union share drafts, and demand
deposits at thrifts. If adopted, the Federal
Home Loan Bank Board's proposal to allow
federally chartered S&Ls to offer payment
order accounts would introduce still another
transactions instrument.
With ATS and the development of these
alternative forms of payment, current M-1 has
become a less comprehensive measure of
transactions balances. Furthermore, other
developments have also greatly increased the
liquidity of savings accounts, making it much
easier for savings accounts at commercial
banks and at thrift institutions to be used for
transactions purposes.
In addition to ATS, preauthorized
payments can be made from savings accounts,
and funds can be transferred from savings ac­
counts to checking accounts by telephone.
Point-of-sale (POS) terminals allow S&L
customers to withdraw funds from their
savings accounts and make deposits through
use of remote terminals at retailers. And
businesses and domestic governmental units
can hold savings accounts at commercial
banks, a development that allows them to
hold highly liquid interest-earning deposits
instead of demand balances.
While savings deposits have become
more liquid, small time deposits at commer­
cial banks and thrift institutions have general­
ly become less liquid. As the regulatory ceil­
ing rates on four, six, and eight-year time
deposits were increased, depositary in­
stitutions were able to issue longer-term, less
liquid time deposits, lengthening the average
maturity of their time deposits. The recent in­
troduction of six-month money market cerEconomic Perspectives

Chronology of developments in the 1970s affecting the character
of the public’s monetary assets
I. Developments leading to new transactions
June 1972 State-chartered MSBs began offering
negotiable orders of withdrawal (NOWs) ac­
counts in Massachusetts.
Sept 1972 State-chartered MSBs began offering
NOWs in New Hampshire.
Jan 1974 Depositary institutions in Mass­
achusetts and New Hampshire authorized to
offer NOWs.
Oct 1974 Temporary experimental share draft
programs first approved for federal CUs.
Mar 1976 Depositary institutions in Connec­
ticut, Maine, Rhode Island, and Vermont
authorized to offer NOWs.
May 1976 State-chartered MSBs and S&Ls in
New York State authorized to offer consumer
demand deposits. (Prior to this time they could
offer payment orders of withdrawal (POW)
deposits. In addition, thrift institutions in some
states have been permitted to offer noninterest­
earning transactions balances to households.
State-chartered S&Ls in Illinois, for example,
have been able to offer noninterest-bearing
negotiable orders of withdrawal (NINOWs) ac­
counts since Oct. 1975.)
Mar 1978 Final regulations for permanent
share draft programs at federal CUs became
Nov 1978 Depositary institutions in New York
State^authorized to offer NOWs.

Sept 1975 CBs permitted to make preauthor­
ized third-party nonnegotiable transfers from
savings accounts for any purpose.
Nov 1978 Prearranged automatic transfer ser­
vices (ATS) from savings balances at CBs and
thrifts having transactions balances authorized.
III. Developments expanding liquid
investment alternatives available
Early 1974 Money market mutual funds came
into existence on a large-scale basis. (These
funds, which invest in money market in­
struments, allow their shareholders to redeem
shares by checks drawn on accounts established
at designated banks, by wire transfer, or by
Nov 1974 Savings accounts at CBs for domestic
government units permitted.
Nov 1975 Savings accounts at CBs for busi­
nesses, up to $150,000 per account per
customer, permitted.
IV. Developments affecting nature of
time deposits
Jan 1970 Increase in interest rate ceilings on
two-and-one-half year deposit approved.
Jun 1970 Interest rate ceilings on time deposits
of $100,000 or more maturing in less than 90 days
May 1973 Interest rate ceilings on time deposits
of $100,000 or more maturing in 90 days or more

Nov 1978 Federal Home Loan Bank Board
proposed authorizing federally chartered S&Ls
to offer payment order accounts (POAs).

Jul 1973 Increase in interest rate ceilings on
four-year deposit approved.

II. Developments increasing liquidity of
savings accounts

Jul 1973 Interest rate ceilings on multiple
maturity time deposits of $100,000 or more

Sept 1970 S&Ls permitted to make preau­
thorized nonnegotiable transfers from savings
accounts for household-related expenditures.
Jan 1974 Point-of-sale (POS) terminals permit­
ting remote withdrawal of deposits from savings
balances at S&Ls allowed.
Apr 1975 Telephone transfers from savings
balances at CBs permitted. (Telephone transfers
from savings balances at thrift institutions have
been allowed since the 1960s.)
Apr 1975 S&Ls permitted to make preauthor­
ized third-party nonnegotiable transfers from
savings accounts for any purpose.

Federal Reserve Bank of Chicago

Jul 1973 Substantial penalty on early with­
drawal of time deposits imposed.

Dec 1974 Increase in interest rate ceilings on
six-year deposit approved.
Jun 1978 Increase in interest rate ceilings on
eight-year deposit approved.
Jun 1978 Six-month money market certificates
with ceiling rate tied to 6-month Treasury bill
rate authorized.
CBs: commercial banks.
CUs: credit unions.
MSBs: mutual savings banks.
S&Ls: savings and loan associations.


tificates (MMCs) has tended to shorten the
average time deposit maturity, but the liquidi­
ty of MMCs as well as other small time
deposits has been lessened by the imposition
of penalties for early withdrawal.
Also included in current M-2 and M-3are
some large time deposits, negotiable and
nonnegotiable, that are more like the ex­
cluded large negotiable CDs of weekly re­
porting banks than either the savings or
small time deposit components of current
M-2 and M-3. Since the regulatory ceiling
rates on time deposits of $1 0 0 ,0 0 0 or more
were suspended, banks and thrifts have tend­
ed to issue these large deposit liabilities in
ord er to offset cyclical movements
in other deposit liabilities.
Banks have also intensified use of non­
deposit sources of funds in recent years. In
particular, they have increased their reliance
on security repurchase agreements (RPs) with
customers. These RPs give a customer a highly
liquid and earning asset as a safe alternative to
holding deposits.
The public's more intensive use of cash
management techniques has reduced the
level of demand deposits needed to conduct
transactions. Through use of such techniques
as lock boxes, wire transfers, informationretrieval systems, and cash-concentration ac­
counts, businesses especially have been able
to invest funds in RPs, commercial paper, and
treasury bills that would otherwise have been
held as demand deposits. The incentive to
make use of these techniques has increased
with the rise in interest rates.
Because of these changes, the meaning
of the monetary aggregates as they are now
defined has been altered, making movements
in the aggregates difficult to interpret. The ex­
perience of the past few years further sug­
gests that relationships between the current
monetary aggregates and GNP may have also
changed. It appears, therefore, that new
definitions are needed. Furthermore, as
regulatory changes and financial innovations
will most likely continue, further refinements
in the definitions of the monetary aggregates
may be needed in the future.


Proposed monetary aggregates

Four redefined monetary aggregates
have been proposed to replace those current­
ly published. Because no one measure of
money is adequate for all purposes, the
separate components of the proposed
monetary aggregates and such related finan­
cial assets as RPs would also be published.
In the proposed money stock measures,
similar types of deposits are aggregated across
depositary institutions. In developing these
measures, two questions were asked. First, do
the assets in the aggregate serve as mediums
of exchange—that is, as transactions
balances? Second, can the assets be readily
converted into transactions balances?
Once these questions were answered,
other considerations were taken into account
in proposing definitions. One was the
availability of data. Another was the
relationship of the proposed measures to
other variables, particularly GNP. Still another
was the ability of the Federal Reserve to con­
trol the proposed aggregates.
The proposed M-1 measure was design­
ed to measure domestic transactions balances
more adequately than current M-1. Proposed
M-1 adds to current M-1 the new
transactions-related savings deposits at com­
mercial banks and thrift institutions—NOW
accounts, ATS balances, credit union share
drafts, demand deposits at such thrifts as
mutual savings banks, and, if approved, S&L
payment order accounts. In line with a
recommendation of the Bach Committee, de­
mand deposits of foreign commercial banks
and official institutions are excluded. This is
because foreign deposits are used primarily
for international transactions and inter­
national reserves.4
Thus far, the new transactions balances to
be added are smaller than the foreign-related
demand deposits to be excluded so that
proposed M-1 is smaller than current M-1.
And while growth rates for the two series have
been quite similar, they are likely to diverge in
the future as transactions-related savings
4lmproving the Monetary Aggregates: Report, p. 4.

Economic Perspectives

balances are used more widely.
Proposed M-1+ adds savings accounts at
commercial banks other than ATS and NOWs
to proposed M-1. As a result, except for
the exclusion of demand deposits of foreign
commercial banks and official institutions,
proposed M-1+ is basically the same as
current M-1+. Recognizing the increased li­
quidity of commercial bank savings deposits,
the Bach Committee had suggested that an
ag greg ate lik e proposed M-1+ be
considered .5
There is some evidence suggesting that
savings accounts at commercial banks have
been more liquid than those at thrift in­
stitutions.6 But as the public adjusts to ATS,
developments could limit the usefulness of
proposed M-1+ to a transitional role.
The third redefined aggregate is pro­
posed M-2, which adds savings balances at all
depositary institutions to proposed M-1. Un­
like current M-2, which adds the increasingly
dissimilar savings and time deposits at com­
mercial banks to current M-1, proposed M-2
aggregates similar deposits across depositary
institutions. Like proposed M-1+, an
aggregate like proposed M-2 had been
suggested by the Bach Committee .7 And
while commercial bank savings accounts may
be slightly more liquid, there is evidence that
savings accounts at different institutions are
good substitutes for one another.8*
The fourth redefined measure is pro­
posed M-3, made up of proposed M-2 plus all
time deposits at all depositary institutions
regardless of denomination, maturity, or
negotiability. As with proposed M-1 and
proposed M-2, similar deposits are summed
across all depositary institutions. By including
all deposit liabilities of all depositary in­
stitutions, proposed M-3 represents the

In the proposed monetary aggregates, similar types
of deposits are aggregated across depositary institutions

Com ponents

June 1978

(billions of dollars,
1. M-1 . . . .

2. M-1+ . . .

3. M-2 . . . .

4. M-3 . . . .

not seasonally adjusted)
C u rren t M-1
PLUS: NO W balances
C re d it union share drafts
Demand deposits at thrifts
ATS savings
LESS: Demand deposits of foreign
com m ercial banks and official
Proposed M-1
PLUS: Savings balances at com m ercial banks3


Proposed M-1
PLUS: Savings balances at all depositary institutions5


Proposed M-1
PLUS: A ll tim e and savings deposits
(including large tim e deposits)
at all depositary institutions5




'Consists of NO W balances in New England states. In Novem ber
1978, NO W accounts w ere authorized in New York State and by
M arch 7, 1979, the stock of N O W balances at depositary institutions
in New York is estimated to have been $1.0 billion.
A/Vould also include paym ent order accounts (PO A ) at savings and
loans, if the current Federal Hom e Loan Bank Board proposal is
adopted. ATS savings w ere first offered on Novem ber 1,1978, and by
M arch 7, 1979, estimated ATS balances w ere $5.7 billion.
3Total does not equal the sum of the com ponents because of other
m iscellaneous adjustments to the total.
‘ Excludes NO W and ATS savings balances at com m ercial banks.
E xc lu d e s all N O W , A TS, PO A (if introduced), and credit union
share draft balances.
SO U R C E: “ A Proposal for Redefining the M onetary Aggregates,”

Federal Reserve Bulletin, January 1979, p. 17. Data in the table do not
reflect the benchm ark revision to the m oney stock data announced in
the February 1979 Bulletin.

broadest of the suggested monetary
Because of the growing importance of
nondeposit sources of funds, particularly RPs,
a monetary aggregate that also included non­
deposit liabilities of depositary institutions
might be useful. Data limitations, however,
impede construction of such an aggregate at
this time.

5Improving the Monetary Aggregates: Report, p. 11.
William A. Barnett, "A Fully Nested System of
M o n e ta ry Q u an tity and Dual User Cost Price
Aggregates,” (Board of G overnors of the Federal Reserve
System, Division of Research and Statistics, Econometric
and C o m p u te r A p p licatio n s Section, November
1978: processed), p. 2.

7Improving the Monetary Aggregates: Report, p. 11.
8Barnett, p. 2.

Federal Reserve Bank of Chicago

Data availability

In theory, concepts of money that satisfy
the user's criteria can be developed. In prac­
tice, however, lack of data or availability of
only poor data can hamper construction of a
series corresponding to theoretical spec11

ifications. Furthermore, construction of a
series based on data that are not timely can
limit its usefulness for policy purposes.
An example is the poor quality of data on
RP liabilities of banks held by the nonbank
public. Without good data, these liabilities
cannot be included in the proposed
redefinitions of the monetary aggregates.
Similarly, some transactions balances, such as
money market mutual funds and traveler's
checks issued by nonbanks, are excluded
from proposed M-1 primarily because suf­
ficient data are not available .9
Given current data sources, monthly es­
timates of the proposed aggregates can be
made. However, the first published monthly
data are apt to be less reliable than current
data and subject to greater revision. This is
primarily because of the lag in obtaining
information on transactions and ordinary
savings balances at thrift institutions. Weekly
estimates of commercial bank deposits are
available, but lack of weekly information on
deposits at thrift institutions would introduce
greater uncertainty into estimates of the
proposed monetary aggregates. Publication
of data on the proposed aggregates could be
delayed, of course, or, in line with the
recommendation of the Bach Committee,
more timely information could be gathered
from institutions that are not members of the
Federal Reserve System.10 Indeed, efforts are
under way to obtain better data from non­
member institutions.
9ln addition, infrequency or unavailability of data has
precluded complete implementation of all of the Bach
Com m ittee’s recomm endations that interinstitution
deposits be consolidated. (Improving the Monetary
Aggregates: R e p o rt, pp. 12-14.) The committee
recomm ended that deposits held by depositary in­
stitutions at other institutions for the purpose of servicing
the deposits included in an aggregate be consolidated
rather than com bined. To com bine the interinstitution
deposits results in double-counting and, therefore, in an
overstatement of the public's monetary assets. W here
possible, the proposed aggregates w ere constructed with
these consolidation principles in mind. Insufficient data,
however, resulted in a “ not negligible” amount of in­
terinstitution deposits being com bined rather than co n ­
solidated. See "A Proposal for Redefining the Monetary
Aggregates,” p. 32. See also the appendix to the above ar­
ticle “ Appendix: Data Sources and Construction of the
Proposed M onetary Aggregates,” pp. 40-41.

10Improving the Monetary Aggregates: Report, p. 3


Empirical evidence

One criterion that is often used in choos­
ing between alternative definitions of money
is the relative strength of the relationship
between the various money measures and
other variables, particularly GNP. The staff of
the Board of Governors prepared several
econometric studies investigating the em­
pirical relationships between primarily GNP
and both current and proposed monetary
aggregates.11 The evidence from these studies
is somewhat inconclusive. The proposed
aggregates appear neither substantially better
nor worse than the current aggregates. But
some of the evidence for the most recent
period tends to indicate a marginally stronger
relationship between GNP and the proposed
However, empirical studies comparing
current and proposed aggregates should be
analyzed with caution. Use of a monetary
measure whose meaning has changed limits
the usefulness of econometric evidence
based on the measure. Because the character
of monetary assets has changed, current
monetary aggregate relationships that once
held are not likely to be as strong in the
future. Likewise, recent changes may lead to
stronger relationships between the proposed
aggregates and other variables than in the

A final consideration is the ability of the
Federal Reserve to influence the levels of the
various monetary aggregates and their rates
of growth. For implementation of monetary
^Richard D. Porter, Eileen M auskopf, David E.
Lindsey, and Richard Berner, “ Current and Proposed
Monetary Aggregates: Some Empirical Issues,” (Board of
Governors of the Federal Reserve System, Division of
Research and Statistics, Econometric and Com puter
Applications Section, January 1979: processed); P. A.
Tinsley, P. A. Spindt, with M . E. Friar,“ Indicatorand Filter
Attributes of Monetary Aggregates: A Nit-Picking Case
for Disaggregation,” (Board of Governors of the Federal
Reserve System, Division of Research and Statistics,
Special Studies Section, O ctob er 1978: processed); and
Barnett. The results of these studies are summarized in “ A
Proposal for Redefining the Monetary Aggregates.”

Economic Perspectives

Proposed M-1 level is lower
than current M-1 due to
exclusion of foreign deposits
billion dollars

Rates of growth, however,
are quite similar

policy, it is not enough for an aggregate to be
closely related to the ultimate objectives of
policy. The Federal Reserve must also be able
to influence an aggregate through available
instruments of monetary policy. The extent of
control over a particular aggregate depends
largely on the operating procedures the
Federal Reserve uses.12
If the Federal Reserve uses a reserves
operating target, control over a particular
monetary aggregate is increased if the
deposits in that aggregate are subject to
reserve requirements set by the Federal
Reserve .13 Under a reserves operating
procedure, the Federal Reserve is likely to
have less direct control over the proposed
monetary aggregates than over the current
aggregates. This is because deposits at thrift
12Kenneth J. Kopecky, “The Relationship between
Reserve Ratios and the Monetary Aggregates under
Reserves and Federal Funds Rate Operating Targets,”
Staff Econom ic Studies 100 (Board of Governors of the
Federal Reserve System, Decem ber 1978).
1 Monetary control over a particular aggregate is
further enhanced the more similar and higher the reserve
requirement ratios are against the various deposits in­
cluded in the aggregate, assuming a reserves operating

Federal Reserve Bank of Chicago

institutions are not covered by Federal
Reserve requirements.
If the Federal Reserve uses an interest
rate operating target, control over a monetary
aggregate depends primarily on the sensitivi­
ty of demand for that aggregate to changes in
interest rates. Empirical estimates of demand
for the various monetary aggregates, pro­
posed and current, suggest that if the Federal
Reserve uses an interest rate operating target,
control over the proposed aggregates would
be about the same as that over the current

Four redefined measures have been
proposed to replace the six monetary aggre­
gate measures the Federal Reserve currently
publishes. All the proposed monetary
aggregates would include similar deposits at
all depositary institutions. By including trans­
actions accounts at thrift institutionsas well as
commercial banks, proposed M-1 would be a
more accurate measure of the public’s
transactions balances than current M-1.
Adoption of the proposed aggregates
would have several implications for monetary
policy. Unless new information sources were
developed, information on the proposed
monetary aggregates would not be as timely
as now or as reliable on a current basis. More
uncertainty about the amount of "money”
available could impair implementation of
monetary policy. Similarly, given its current
range of reserve requirement authority, the
Federal Reserve could have less control over
the proposed aggregates than over the
current aggregates, depending on operating
procedures used.
The proposed monetary aggregates,
how ever, are conceptually closer to
theoretical "money” than the current
measures. Instead of rejecting the proposed
aggregates because of data availability or con­
trollability problems, it would seem more ap­
propriate to continue seeking ways of im­
proving both the timeliness and quality of the
data and the extent of Federal Reserve control
over the proposed measures.


Banks and the securities markets:
the controversy
Larry R. M ote
Commercial banks have tried hard over the
past decade to expand their currently limited
role in the securities markets. Firmsalready in
the securities business have been determined
to prevent any enlargement of that role. The
confrontation could escalate into one of the
most bruising legislative battles in recent
Some banks have argued that they should
be allowed to underwrite municipal revenue
bonds, as well as general obligation bonds, to
offer commingled investment accounts
(essentially, mutual funds), and to engage in
the retail securities brokerage business.
Federal banking law either prohibits banks
from engaging in these activities or, as in the
case of brokerage activities, is ambiguous.
The issues underlying the controversy
date, at least in embryonic form, back to the
beginnings of American banking. The role of
banks in the securities markets, curtailed
since passage of the Banking Act of 1933, is
understandable only in terms of what was
going on when the act was passed.
This article examines the controversy
over securities activities by tracing the history
of the involvement of banks in securities
markets and describing their current ac­
tivities. A later article will try to sort out the
problems of public policy, separating those
inherent in bank securities activities from
those that were due to abuses since cured by
legislation or changes in business ethics.
Commercial loan theory of banking

From its inception, American banking
was based on the English model. Like their
English brethren, American bankers pro­
fessed to subscribe to the commercial loan
theory of banking—the real-bills doctrine,


which held that the characteristic role of a
commercial bank was to make short-term,
self-liquidating loans for the purpose of
financing industry and trade. The term “ real
bills" derives from the bills serving as
evidence of indebtedness to a bank; the bills
were real in the sense that they were secured
by real goods moving to market.
The theory held that a bankcould ensure
its solvency and liquidity by confining its
lending to this kind of short-term, selfliquidating loan. The theory held further that
adherence to such a policy would result in just
enough money and credit to support the
prevailing level of economic activity, or
“ needs of trade." It would stabilize prices.
Though the subject of controversy for
years, the real-bills doctrine survived well into
this century. It was even incorporated into the
Federal Reserve Act by the requirement that
credit extended to commercial banks by the
Federal Reserve banks be secured by eligible
paper, meaning paper evidencing short-term
loans similar to those envisioned by the realbills doctrine.
The real-bills doctrine has since been
relegated to the dustbin of the history of
economic thought. Long before the doctrine
was thrown out, however, the demand for
credit in a vigorously developing country
produced important departures from its dic­
tates. With few other financial institutions—
and no organized securities markets to meet
the enormous requirements for new fixed
investments—banks were called on very early
to supply a large part of the long-term credit
business demanded.
It was apparent as early as the 1830s that
American banks were heavily into the
business of making long-term loans secured
by fixed assets. It is estimated that, by the

Economic Perspectives

beginning of World War I, a substantial
proportion of commercial bank credit was
going to finance fixed capital. In addition to
extending direct loans, banks were heavy
purchasers of corporate and government
Moreover, although data are scant, banks
appear to have been leading participants in
the underw riting and distributing of
securities in the first half of the nineteenth
century. Failure of the Second Bank of the
United States following its conversion to a
state charter was widely blamed on the bank's
involvement in investment banking. This
criticism was forgotten in the 1860s, however,
as demands for credit during the Civil War set
off another burst of bank underwriting of
By the turn of the century, the role of
commercial banks in investment banking had
become a matter of controversy. In 1902, the
Comptroller of the Currency ruled that the
National Banking Act prohibited national
banks from underwriting and distributing
equity securities.
To get around this restriction, national
banks, led by the First National Bank of
Chicago in 1903, organized state-chartered
affiliates to carry on their securities business.
This response was similar to the earlier
organization of state-chartered trust com­
panies to get around the National Banking
Act's prohibition of trust activities to national
In 1912, the Pujo Committee, a subcom­
mittee of the National Monetary Commis­
sion, recommended that national banks also
be prohibited from underwriting corporate
bonds. The role banks were to play in dis­
tributing government securities in World War
I, however, would soon allay criticism of bank
securities activities.
Banking in the twenties

The 1920s saw a further blurring of the
distinction between commercial banking and
investment banking, occasioned by a sharp
shift in business demand for credit. Largely as
a result of waves of mergers, first around the
Federal Reserve Bank of Chicago

turn of the century and then in the twenties,
large corporations had become dominant in
American business. Having easy access to the
emerging national credit market, cor­
porations often found it better to raise long­
term funds by selling securities than by
borrowing from banks. This tendency was
reinforced in the twenties by the growing
popularity of stock ownership, even by those
with modest incomes.
Corporations cut back on their short­
term borrowing from banks even more
because, after several years of rapid growth in
earnings, they were flush with funds. Many
companies, in fact, entered money markets as
lenders in competition with banks, particular­
ly in call loans for carrying stocks on margin.
To put funds derived from their rapidly
growing deposits to profitable use, banks
sought alternatives to the shrunken market
for short-term commercial loans. One alter­
native was to increase their term lending to
business—loans with maturities of more than
a year. Despite this shift in emphasis, com­
mercial loans declined from over 50 percent
of banks' total earning assets in 1923 to 39 per­
cent in 1929. As a proportion of total loans,
commercial loans declined from 71 percent in
1923 to 54 percent in 1929.
Within the bounds of regulatory con­
straints, banks also increased their purchases
of corporate, utility,and municipal bondsand
expanded their participation in consumer
and mortgage lending. As two eminent bank­
ing authorities wrote in 1933, “ . . . American
banks ceased to a large extent to be commer­
cial banking institutions and became instead
investment trusts." But for all their efforts to
compensate for the loss of their traditional
lending business, banks' share of total credit
fell from 25 percent in 1923 to 22 percent in
To maintain their preeminence among
financial institutions, banks relied more and
more on their securities activities, either
directly (the McFadden Act of 1927 explicitly
authorized national banks to underwrite in­
vestment securities) or through securities af­
filiates. They were so successful that by 1929
banks and their affiliates were underwriting

over half the new issues reaching the market.
Banks appeared to have made the transition
from narrowly focused short-term business
lenders to general-purpose financial
The banking crisis

Then the bottom fell out. The crash of
1929 and the ensuing Depression and banking
holiday brought to grief not only most of the
banking system, including some large banks
and their securities affiliates, but also many
depositors and small investors. After the
banking crisis in 1933, when some4,000 banks
failed, Congress conducted several inves­
tigations of the banking system and passed
banking reform legislation.
The most sensational of the Con­
gressional investigations was conducted by
Ferdinand Pecora, counsel for the Senate
Banking and Currency Committee. This in­
vestigation focused on the securities activities
of banks and their affiliates in the 1920s.
Abuses by several banks, especially one of the
largest New York banks, and their officers and
affiliates captured the public's imagination
and aroused its indignation in a way not seen
again until the Watergate affair.
Among these abuses were the invest­
ment of deposit funds in speculative foreign
bonds, the promotion of securities sales on
behalf of affiliates, excessive lending to af­
filiates, speculation by affiliates in the stock of
parent banks, a bank president selling the
stock of his own bank short—and making a
fortune in the process—and indirect payment
of huge salaries to bankers through their af­
filiates. The responses of the government and
the public were limited at the time to ex­
pressions of outrage. None of the activities
was strictly illegal. But it is clear that
revelations coming out of the hearings had a
great deal to do with the kind of banking
reform legislation that was adopted.
The Banking Act of 1933

The centerpiece of banking legislation of
the thirties was the Banking Act of 1933. Often

called the Glass-Steagall Act after its sponsors,
Senator Carter Glass and Representative
Henry Steagall, this act was later reenacted
with significant revisions as the Banking Act of
Although the act dealt with a host of
banking matters—including the size and
composition of the Federal Reserve Board,
membership in the Federal Reserve System,
and branching by national banks—the two
key provisions of the act were the establish­
ment of federal deposit insurance and, of
most interest here, the separation of commer­
cial banking from investment banking. Sec­
tion 16 of the 1933 act as amended restricts
investments of national banks. The section
reads in part:
. . . The business of dealing in securities
and stock by the association shall be
limited to purchasing and selling such
securities and stock without recourse,
solely upon the order, and for the ac­
count of customers, and in no case for
its own account, and the association
shall not underwrite any issue of
securities or stock: Provided, that the
association may purchase for its own ac­
count investment securities under such
limitations and restrictions as the
Comptroller of the Currency may by
regulation prescribe . . . As used in this
se c tio n the term "in vestm e n t
securities" shall mean marketable
obligations, evidencing indebtedness
of any person, copartnership, associa­
tion, or corporation in the form of
bonds, notes and/or debentures com­
monly known as investment securities
under such further definition of the
term "investment securities" as may by
regulation be prescribed by the Comp­
troller of the C u rre n cy. . . .The
limitations and restrictions herein con­
tained as to dealing in, underwriting
and purchasing for its own account, in­
vestment securities shall not apply to
obligations of the United States, or
general obligations of any State or of
any political subdivision thereof . . .
Economic Perspectives

Section 5(c) of the 1933 act applied the same
restrictions to state member banks. Section 20
outlaws bank security affiliates:
After one year from June 16,1933,
no member bank shall be affiliated in
any manner described in subsection (b)
of section 221a of this title with any cor­
poration, association, business trust, or
other similar organization engaged
principally in the issue, flotation, un­
derwriting, public sale, or distribution
at wholesale or retail or through syn­
dicate participation of stocks, bonds,
d e b e n t u r e s , notes, or othe r
securities . . .
Section 21 of the act forbids individuals and
companies in the investment banking
business from engaging in deposit banking,
and vice-versa.
Whatever the merits of the case against
the securities activities of banks, the Banking
Act of 1933 unequivocally restricted them. But
the separation of banks from securities
markets was not complete.
Banks were expressly permitted to buy
and sell securities, including equities, at the
order of customers for their accounts. Banks
were also allowed to purchase some types of
debt securities for their own portfolios and to
underwrite Treasury issues and general
obligation bonds of state and local
governments. The act did not explicitly men­
tion the authority of banks to serve as advisors
to investment companies or other in­
stitutional investors or prevent bank trust
departments, as fiduciaries or agents, from
managing the assets of individuals or cor­
porations, including the purchase and sales of
both debt and equity securities. In a recent
suit brought by the Investment Company In­
stitute, however, a federal appeals court held
that bank holding companies were
prohibited by the Bank Holding Company Act
from acting as investment advisors to closedend investment companies and strongly
hinted that banks were prohibited from such
activity by the Banking Act of 1933.
Federal Reserve Bank of Chicago

Reentry into the securities markets

For many years after the banking crisis of
the thirties, banks were generally content
with the restrictions, an attitude reinforced by
the depressed state of securities markets. Not
until the early sixties—when the economy
and the stock market had both recovered
from the Depression and banking was
becoming more competitive under the
stimulus of reviving loan demand and, in at
least some respects, a more relaxed
regulatory environment—did banks begin to
test the limitations put on their securities ac­
tivities in 1933.
Municipal revenue bonds. One of the
first tests of these limitations came with an
effort by national banks to underwrite
municipal revenue bonds. Revenue bonds
are debt securities with repayments that de­
pend on revenue from a particular source,
such as highway tolls. The authority of banks
to underwrite general obligation bonds,
generally construed to mean bonds backed
by the general taxing power of the mu­
nicipality, was expressly recognized in the
Banking Act of 1933.
The Comptroller of the Currency, in a
somewhat strained interpretation, ruled that
the term “ general obligation" had not been
used in a strict technical sense in the act. In
view of the alleged ambiguity and in light of
studies showing that commercial bank entry
into underwriting would increase competi­
tion and reduce borrowing costs for state and
local goverments, in 1963 the comptroller
authorized national banks to underwrite cer­
tain bonds issued by the state of Washington
that were previously considered ineligible.
He followed this ruling with others that
broadened still further the definition of
general obligation.
As a result, the comptroller was sued by
an investment banking firm in the business of
underwriting revenue bonds and in 1966 the
ruling was overturned. Since then, banks have
lobbied for statutory authority to underwrite
revenue bonds. For the first time, they may be
close to succeeding.
Commingled investment accounts. The

Comptroller of the Currency tested the limits
of the Banking Act of 1933 with another ruling
in 1963. In this case, the comptroller approved
the application of First National City Bank of
New York to serve as investment advisor to a
commingled managing agency account—
essentially, a bank-sponsored mutual fund
operated by the bank's trust department.
Authority for banks to commingle in­
dividual trust accounts, pooling funds for in­
vestment purposes, is well established.
Similarly, their management, in an agent's
capacity, of large individual accounts is uni­
versally accepted as perm itted under the law.
What had not been tried before was the com­
bination of these two powers—management
of commingled accounts on an agency basis.
In a landmark decision, the Supreme
Court upheld the district court decision
(reversed by the Court of Appeals) that found
the Comptroller of the Currency had exceed­
ed his authority in ruling that national banks
might engage in this combined activity. The
court held that the collective investment fund
violated both sections 16 and 21 of the Bank­
ing Act of 1933.
Automatic investment services. Com­
petitors believe that the particular manner in
which banks have expanded into some
otherwise legal activities violates the act.
Some banks, for example, have interpreted
their authority under the act to buy and sell
securities, “ upon the order, and for the ac­
count of customers/' to mean they are free to
enter the retail securities brokerage business.
As a move in that direction, banks have
obtained permission of the Comptroller of
the Currency to offer automatic investment
service (AIS) accounts. Through these ac­
counts, customers authorize the bank to
deduct regular amounts from their checking
accounts every month to buy a number of
preselected stocks. The list of stocks a
customer can choose from is usually limited,
as for example to the 25 stocks on the New
York Stock Exchange with the largest
To hold down commission costs, funds
from all the banks' AIS accounts are pooled so
the stocks can be bought in large blocks. The

price a customer is charged for a stock is
usually the average price paid for the stock
that month. It is not the price paid in any one
The appeal of these accounts is their
comparatively low commission costs and the
convenience they give customers, many of
whom might not otherwise invest in stocks.
But the accounts have not come up to expec­
tations. Originally expected to attract a large
number of accounts and a great volume of
funds, AIS plans have not been as widely
accepted as banks had hoped. Several banks
have dropped the service. At least two large
banks are now negotiating with Merrill Lynch,
the country's largest brokerage firm, to serve
as agents in offering its Sharebuilder
program—which is similar to an AIS plan—to
customers of the banks.
Nevertheless, in offering AIS plans in the
first place—and despite making all sales and
purchases of stock through established
brokers or dealers—banks raised the spectre
of their eventually entering the brokerage
business on a full scale. Indeed, Chemical
Bank of New York has gone so far as to offer
the general public brokerage services on an
agency basis. This has raised the opposition of
those already in the business, who argue that
such services may be offered only as an ac­
commodation to existing customers, and only
at a price at or below cost.
Dividend reinvestment plans. More
successful has been the banks' introduction
of dividend reinvestment plans (DRP). Under
these plans, stockholders authorize com­
panies in which they own shares to send their
dividend payments directly to the bank.
There, the dividends of all participating
stockholders in a company are pooled to buy
more shares. Some plans allow stockholders
to commit funds in addition to their
As many as 500 companies participate, in­
cluding many of the largest in the country in
terms of market value of outstanding shares.
Ordinarily, 5 to 12 percent of the shareholders
of companies represented in the plans par­
ticipate. The number of participating
shareholders, estimated at over a million, is
Economic Perspectives

expected to grow.
Private placem ents. Also growing
rapidly—but seen as much more threatening
by the securities industry—are the private
placement activities of banks and their af­
filiates. A private placement is a negotiated
sale of securities to private investors that is ex­
empt from the registration requirements for
public issues of securities. The investors, often
large insurance companies or other in­
stitutions, are sophisticated.
The bank advises the issuer on such
details as the appropriate interest rate,
maturity, indenture provisions, and timing of
the sale. It helps locate potential investors and
may help in negotiating with them.
Private placements are becoming impor­
tant as an alternative to both public issues of
securities and direct bank loans. According to
estimates, bank-assisted private placements
have increased from $129 million in 1972 to
$1.5 billion in 1977.
Although most private placements are
assisted by financial institutions other than
commercial banks, mostly investment bank­
ing firms, the commercial bank share of the
dollar volume of assisted placements rose
from 1.8 percent in 1972 to 7.3 percent in 1975
and 1976 before declining to 6.7 percent in
Five large banks accounted for an es­
timated 77 percent of the dollar volume of
bank-assisted private placements in 1977. The
largest of these, however, ranked only twelfth
among advisors in solo private placements, as
opposed to private placements co-managed
by two or more institutions. It was the only
bank in the top 20.
The situation could, nevertheless,
change dramatically if banks aggressively seek
to expand their role in private placements and
are allowed to do so.
Current controversy

Controversy has grown out of the recent
incursions banks have made—or tried to
make— into securities activities they had
either neglected or thought prohibited to
them by the Banking Act of 1933. Securities
Federal Reserve Bank of Chicago

brokers and dealers, investment bankers, and
their trade associations have countered in­
roads by the banks in some cases with lit­
igation and in others with appeals to bank
regulatory agencies for rulings restricting
bank securities activities. In at least one case—
that of Merrill Lynch's Cash Management
Account—the securities industry has struck
back with a plan that, because it allows
customers to write checks against the balance
in their accounts, is perceived by bankers as
unauthorized entry into banking.
More broadly, they and other individuals
and groups concerned with the expansion of
banks into securities markets are pressing for
a general review of the role of banks in these
markets. The ultimate goal appears to be the
enactment of clarifying—and presumably,
more restrictive— legislation.
To some extent, the securities industry's
opposition is simply the predictable response
of an industry threatened with new competi­
tion. Unless there are compelling arguments
to the contrary, protection from competition
has not been considered a suitable goal of
Bank involvement in the securities
m arkets, nevertheless, raises several
legitimate issues that need to be examined
before public policy can be made. These
issues include, but are not limited to:
• The likelihood of conflicts of interest
when banks (1) lend to companies in which
they buy stock as agents for their
customers or (2) arrange private placements
of securities for companies that use the
proceeds to pay off loans to the bank.
• The effect on bank solvency of the
failure of an investment company the bank
serves as an advisor.
• The effect of bank managing agency
and trust activities on the institutionalization
of the stock market and market liquidity.
• The possibility of “ voluntary tie-ins'' in
which, to increase their chances of obtaining
a loan, customers use other services of a bank
without regard for their own merits.
• The dangers to investors of banks not
being subject to the broker examination,
“ suitability" requirements, and prompt ex­

ecution standards the SEC imposes on other
• The danger of increased concentration
of resources from banks exploiting the com­
petitive advantages of their exclusive
Some of these issues have little sub­
stance. Others have been handled by legisla­
tion. Some, however, particularly those in­
volving actual or potential conflicts of
interest, are real and have not been dealt with
adequately. In those cases, it is still open
whether regulation can provide an adequate
remedy or whether a structural solution such
as divorcement is needed.

But bank entry into securities activities
offers potential public benefits as well as
possible dangers. Where entry is free and ex­
isting firms are exposed to new competition,
the result is often better service, more innova­
tion, a greater variety of services, and lower
prices than where new competition is ex­
cluded. Consequently, a review of the
securities activities of commercial banks
should consider not only the need for forging
new restraints but also the possibilities for
loosening some old shackles. A subsequent
article will discuss some of these issues and
the costs and benefits of proposed remedies
in more detail.



Economic Perspectives

Holding company affiliation and scale
economies in banking
Dale S. Drum
How affiliation with a holding company
affects the cost structure of banks has been a
controversial subject in banking for some
time. In support of their applications to ac­
quire banks, holding companies argue that
economies in the operation of banks can be
achieved through affiliation. If these oppor­
tunities for economies do exist and if these
economies are passed on to the public, then it
may be argued that the resulting public
benefits can be presumed to offset, in part or
perhaps in whole, any anticompetitive effects
present in the application.
While holding company applicants and
their advocates cite scale economies as an
argument for acquisitions, they seldom sup­
port their position with concrete data. On the
other hand, opponents rarely support their
views either. Empirical studies examining this
issue also have reached mixed conclusions.
A study of 208 Seventh District banks was
undertaken to explore the impact of affilia­
tion on the cost structure of banks. These
banks ranged from $6 million to $650 million
in asset size. The effect of branching on the ef­
ficiency of these banks was also examined.
Results of the Study. The results of the
study indicate that independent banks—
banks not affiliated with either a one-bank or
a multibank holding company—are subject to
at least moderate economies of scale. That is,
the percentage increase in total cost is less
than the percentage increase in output.1 For
N O TE: A copy of the more technical working paper
entitled “ The Effect of Holding Com pany Affiliation
Upon the Scale Economies of Banks/’ Research Paper No.
79-2, is available from the Public Information Center,
Federal Reserve Bank of Chicago.
’As employed in this study, output is estimated as
loan revenue plus revenue from securities plus income
from other sources. Thus bank output is viewed as the
value of credit extended plus the value of other services
performed by the bank. Total cost is defined as total
operating cost less all service charges received by the

Federal Reserve Bank of Chicago

independent banks, an increase in output of
10 percent increases total cost about 9.5 per­
cent. Since cost rises more slowly than output,
per unit cost declines.
Banks in SMSAs typically incur slightly
higher costs than do comparable non-SMSA
banks. Competitive pressures may force
SMSA banks to engage in more advertising or
to offer comparable services either free or at
reduced prices. Higher costs can also be
associated with an urban environment as, for
example, higher taxes or real estate prices.
In addition, banks with branches appear
to have slightly higher costs than banks
without branches. This cost difference does
not become particularly significant, however,
until the bank has at least three branches.
Overall, affiliation with a one-bank
holding company has no significant effect on
scale economies. In fact, in most cases, the
o n e -b a n k h o ld in g co m p any is an
organizational shell that merely transfers
ownership of the bank from individuals to a
corporation. Operating efficiency is probably
not affected by this change in the form of
ownership, although it may affect net income
due to the difference in the tax status ac­
corded a corporate entity.
Multibank affiliates, on the other hand,
are slightly less efficient than banks not af­
filiated with holding companies. Although of
marginal statistical significance, a 10 percent
increase in the output of these affiliate banks
increases total cost about 9.7 percent. There
seems to be no empirical justification, then,
for the assertion that affiliation with a mul­
tibank holding company will produce scale
economies not otherwise available to in­
dependent banks.
Other findings. Additional information
can be gleaned by grouping the banks into
different size classes. Scale economies show
up predominantly in medium and medium21

large banks. Banks having assets from $50
million to $100 million are considered
medium-sized, while banks with assets from
$100 million to $200 million are considered
For medium-sized independent banks, a
10 percent increase in output will increase
total cost approximately 8.8 percent. A similar
increase in output for a medium-large
independent bank increases total cost 9
Branching affects medium-large and
large banks more than the other groups. In
both groups, banks with branches incur
slightly higher costs than comparable banks
without branches.
Affiliation with a one-bank holding com­
pany has a negligible impact on the scale
economies of all but medium-sized banks.
These affiliates are somewhat more efficient
than independent banks of the same size,
with a 10 percent increase in output in­
creasing total cost only 8.5 percent. This com­
pares to an 8.8 percent increase in total cost
for medium-sized independent banks.
Affiliation with a multibank holding com­
pany tends to reduce the efficiency of all
banks except medium and medium-large
banks. These banks share the same scale
economies as their independent counterparts
of the same size.
Policy implications. The Bank Holding
Company Act provides the Board of Gover­
nors of the Federal Reserve System with
guidelines for evaluating applications to es­
tablish a holding company or to acquire a
bank in the case of an existing holding com­
pany. One of the principal concerns of the act
is the probable effect such a holding company
will have upon competition in the relevant
market. An application that, if approved,
would result in adverse competitive effects
will be denied unless there is evidence of suf­
ficient public benefits to clearly outweigh the
anticompetitive effects.
In making its decision, one of the criteria
the Board considers is whether an acquisition
will result in gains in efficiency which will
benefit the public. Section 4(c)(8) of the Act,
which deals with the acquisition of nonbank

firms, requires the Board to consider gains in
efficiency as one of the factors that could
potentially offset adverse effects. No such
specific requirement exists in section 3,
however, which applies to bank acquisitions.
Together with the convenience and
needs of the community, the Board is
obligated to consider the financial and
managerial resources and future prospects of
the company. Since these will be affected if
economies are realized, this serves as the
springboard allowing the Board to consider
gains in efficiency as a separate factor in
assessing whether the public benefits will out­
weigh the anticompetitive effects of a bank
Gains in efficiency resulting in reduced
prices or better service are additional benefits
falling within the competitive or convenience
and needs criteria. Gains in efficiency do not
have to be passed on to customers but can
instead be held as higher retained earnings,
thereby improving the capitalization of the
acquired bank. The resulting increase in
financial strength and soundness of the bank
could be a factor weighing favorably for ap­
proval of the application.
Conclusion. The results of this study in­
dicate that banks affiliated with holding com­
panies do not achieve economies of scale
beyond those available to independent banks
of the same size. Therefore, considering
economies of scale as a factor that can be
relied upon to outweigh the anticompetitive
effects of a proposed acquisition has little
merit. The argument simply lacks firm em­
pirical support.
Affiliation does seem to have a positive
effect on scale economies in the case of
medium-sized banks affiliated with one-bank
holding companies. Competitive issues,
however, are seldom a significant factor in
these cases. They are more important in
applications of multibank holding com­
panies, where affiliation appears detrimental
to scale economies of affiliated banks. Only
among medium and medium-large banks do
affiliates of multibank holding companies
manage even to match the scale economies
of independent banks.
Economic Perspectives

The Federal Reserve has - recently
published a 46-page booklet providing a
straightforward summary of consumer
credit rights. Copies are available free of
charge from the Public Information
Center, Federal Reserve Bank of Chicago,